There are many methodologies that can be used to evaluate share prices.
One such methodology, which is called technical analysis, is based on an assumption that prices tend to move in cycles, trends or patterns and that the future movements of a particular share price can be predicted from a study of charts of past behavior.
Another methodology is based on an assumption that the present price of a share reflects all past information about that share, because it represents the sum of the opinions of a large number of analysts and investors. The current market price of the share is thus assumed to follow a Markov process, in which future predictions of the share price can only be made on the basis of probability distributions.
A further methodology, referred to as fundamental analysis, is based on an assumption that a share possesses intrinsic value that can be determined from a careful study of a company's past and current performance. In contrast to the second methodology above, fundamentalists operate under an implicit assumption that sooner or later the market price of the share will move in a direction dictated by fundamental value. A question which plagues fundamentalists is how an investor or analyst should determine fundamental value in advance of such moves in a share price.
This invention is only concerned with fundamental analysis. In order to conduct fundamental analysis, it is first necessary to collect and examine information regarding the past performance of a company, together with an assessment of its strengths and weaknesses. Software to perform such fundamental analysis is known in the art; such fundamental analysis packages provide information relating to share capital, major shareholdings, net asset value (“NAV”), earnings, profits before and after tax, and dividends, cash, loans, margins, return on equity, debt-equity ratio and many other ratios. These fundamental analysis packages enable shares to be ranked according to any one or more of these variables at the instance of the analyst.
However, there is no consensus amongst analysts and investors as to what weight to attach to each of the above-mentioned criteria. Furthermore, the task is complicated by the fact that all the indicators relating to a particular share are not static, but constantly moving either up or down.
There is general agreement amongst analysts and investors, however, that one of the most significant indicators of a share's performance is an earnings trend of the underlying company. Most analysts, when reporting on the share, will make a forecast of earnings per share (“EPS”) for a current financial year and probably for a year or two thereafter. The problem faced by such analysts and investors is how to translate that forecast into a valuation of the share.
An often-expressed opinion is that a standard method of valuing shares is not possible because of the number and variety of factors that have to be taken into account in such a valuation. Complexity of information should, however, not preclude a treatment of it in a standard manner. The same difficulties are faced when assessing the feasibility of a proposed new company project, whether internal or external. The object, both in relation to a project and a share, is to determine its value as an investment. In the case of the former, the standard methodology is to forecast a cash flow for a period such as, for example, ten years, together with a valuation of residual assets at the end of the period. The internal rate of return (“IRR”) of the project is obtained by discounting these figures. There is no reason why this method should not be used to determine the IRR of a share purchase. A procedure would be to discount the forecast flow of dividends for a number of years, together with the proceeds of a notional sale at the end of the period.
The problem with this approach is that the major factor in the calculation, especially with high-growth shares, is pricing the notional sale at the end of the period being assessed. It is illogical to produce the fair price of a share today by a process that is critically dependent on an estimate of its value at some future time.
Analysts and financial writers repeatedly refer to “value” stocks, unlocking “value”, embedded “value” and the like. It is never explained what the word “value” means, or how it can be measured. The private investor thus has no rational or authentic basis for his investment decisions.
A system for evaluating securities that alleviates some of these problems is described in South African patent number 2001/4855 (“ZA2001/4855”).
ZA2001/4855 discloses a system and a method that enables the relative merit of a number of securities to be estimated. The relative merit of a security is expressed as a merit factor that is determined by dividing an estimated price-earnings ratio by a historical price-earnings ratio. The estimated price-earnings ratio (PE) is determined by the following recursive formula:
            PE      k        =                            (                                    g              k                        +            100                    )                ⁢                  (                      1            +                                          PE                                  k                  -                  1                                            ⁢              C                                )                            C        ⁡                  (                      100            +            R                    )                      Where            k      =      1        ,    2    ,          3      ⁢                          ⁢      …      ⁢                          ⁢      n        ,                  ⁢                  PE        0            =              100        RC              and      n    =                            log          10                ⁢        G                              log          10                ⁢        g            and where
R is a prescribed desired percentage return on investment
E is the last reported diluted headline earnings per share (HEPS)
C is a predetermined level of dividend cover at a predetermined level of growth under investigation
G is an estimated growth rate in HEPS during the year following the last year of reporting, and
g is an estimated attenuation ratio of the growth rate of HEPS, measured by the growth rate in one year divided by the growth rate in the next.
However, ZA2001/4855 gives no indication of how the attenuation rate g should be selected. As the estimated PE ratio, and therefore the merit ratio, is highly sensitive to the parameter g, a discrepancy in the value of g can significantly alter the merit rating of a security.
The implicit assumption that the value of the dividend cover C will remain constant irrespective of the level of annual earnings in the future represents another shortcoming in the system proposed by ZA2001/4855.
Furthermore, in the system described in ZA2001/4855, the historical PE ratio must be determined by updating the last reported earnings up to the present. This may be a period of up to twelve months, as the earnings of some securities are only reported annually. The historical PE ratio must be determined by updating the last reported earnings using the growth factor, G. However, where a significant number of months have passed since the last reported earnings, using the same factor of G for updating the last reported earnings to obtain the historical PE ratio and for determining the estimated PE ratio based on future earnings results in inaccuracies. This is because the short-term growth rate in the current year is often abnormally high or low due to transient circumstances.
Finally, in ZA2001/4855 the recursive formula listed above is used to create an array of PEk values that correspond to k=1,2,3 . . . n. The values of k correspond to year numbers, and it follows that the projected PE values are only reflected once for each forecast year. Because the calculated value of n may not be an integer, n must be rounded off to the nearest integer in order to select the value of PEk for k=n from the array of PE values referred to above. In cases where the attenuation rate g is high, the projected PEk values will differ significantly from year to year, resulting in significant rounding-off errors when n is rounded-off to an integer value.